Today's Federal Reserve Open Market Committee meeting ended with no change in interest-rate policy, as was widely expected. However, there are some crosswinds facing the Fed that will have major implications for both stocks and bonds. Here is my take on where the Fed is now and what comes next.
Inflation: Mission Accomplished?
The Fed might have opened this meeting with a champagne toast. The Core PCE deflator, which is the central bank's preferred measure of inflation, came in at 1.9% for the 12 months ending in March. That measure was at just 1.3% as recently as August, far away from the Fed's stated target of 2%. At the time the Fed told us that temporary measures were holding inflation down and it would soon rebound. Not only was their interpretation of the data now vindicated, their decision to continue with rate hikes is also vindicated.
Tellingly, the Fed hardly mentioned the inflation uptick. They changed the sentence describing inflation from "continued to run below 2%" to "moved close to 2%." I think this hints at their nonchalance about the inflation picture. It would be a mistake to assume this means the Fed is going to accelerate the pace of rate hikes. Their internal projections suggest either two or three additional hikes in 2018 and around five hikes total by the end of 2019, and two more in 2020. That projection was already assuming inflation would rebound to around 2%, so unless inflation keeps accelerating (more on this later) the Fed will probably be comfortable at this pace.
It is worth noting that the market is pricing in about 2 1/2 hikes in 2018, slightly less than four hikes by the end of 2019, and then nothing more in 2020. So, while the Fed may not be accelerating, there is room for the market to catch up with where the Fed is.
A Powell Put?
Despite the higher inflation prints, financial markets seem more acutely attuned to the possibility that the Fed is making a mistake by being too hawkish, not too dovish. This is a big reason why stocks have become more volatile the last few weeks as well as why the classic rates/stocks correlation has broken down lately.
Would falling risk assets convince the Fed to slow down rate hikes (i.e., a Powell Put)? Under current circumstances, no way.
If you only look outside of financial markets, you would be hard pressed to find any evidence of a weakening economy: job gains are strong, inflation is picking up, survey data show high business confidence, etc.
Even if we look at earnings so far this season, which have produced mixed reports to be sure, they aren't showing any real signs of broad economic weakness. We're hearing a lot about wage pressure, input cost increases, transportation costs rising, etc. Companies aren't worried about demand for their product, but rather the consequences of a tight economy.
Making sure the economy doesn't get too tight is the Fed's job, so if stocks are falling for that reason, it will encourage the Fed to keep hiking. Certainly, it wouldn't get the Fed to back off.
Could Inflation Keep Accelerating?
It is hard to predict of course, but it would be pretty easy to see the year-over-year Core PCE figure stick at 1.9% or even keep accelerating. Over the last six months, Core PCE has printed at an annualized pace of 2.27%. Meanwhile, the months that are rolling off are lower, so in a sense the comps are getting easier. The prior sixmonths (i.e., March 2017-September 2017) printed at a 1.50% pace.
I don't know if the most recent six months are a good gauge of go-forward inflation. If indeed there were transitory factors holding inflation down last summer, the acceleration now could just be a reversal, which, in and of itself, would be transitory. However, looking beneath the headline data, it looks to me that there is enough momentum to keep PCE around 2% at least for the next several months.
How would the Fed view somewhat higher inflation? It is going to talk about tolerating inflation that's a bit higher. In the release, the central bank added a phrase saying that inflation is expected to "run near" the 2% target, perhaps as a nod to a willingness to allow inflation to get a bit above 2%.
In one sense that's true. In isolation, I don't think the Fed would automatically hike faster just because there was a 2.2% print. Nevertheless, the central bank won't tolerate inflation accelerating past 2%. In other words, if it is just random noise in the data and we bump above 2% for a month and then below 2% another month, that doesn't change the Fed's plans at all. But that isn't the likely story in today's context. That will be happening amidst a tight labor market and a strong overall economy.
For example, let's say that by the September FOMC meeting, Core PCE has printed a couple times at 2.2% YoY. The inescapable conclusion will be that the tight economy has led to higher inflation. They would then definitely hike in September and keep optionality open to December.
What Does This Mean for Markets?
I think this is all a pretty negative story. While I'm not one to call a bear market in risk assets, the Fed's job is getting trickier and trickier, and so, in my opinion, recession risk has gotten a lot higher. And while it is hard to see how the economy falls apart fast enough to get a recession going in 2018, markets will price this in much sooner than an official recession is called.
I still think curve flatteners are the trade here. I'm short 5-year Treasury futures vs. long-bond futures. In ETFs, you can use iShares 3-7 Year Treasury Bond ETF (IEI) to be short the middle part of the curve and iShares 20+ Year Treasury Bond ETF (TLT) to be long longer bonds. I know the curve is pretty flat already but as long as the Fed keeps hiking, the curve will keep flattening. I expect the curve to invert by the time the year is out.
I've been cutting credit risk a bit here, too. If you are long high-yield bonds, I think lightening up is smart. I don't expect some kind of Armageddon and there are pockets of value, but valuation in junk bonds generally is pretty poor and the cycle is getting later and later.
